It’s no secret that the Internet and the companies that operate within the Internet space are always changing. There must be continuous innovation and re-discovery to keep up with the competition to amaze society with the next great development. Consumers have become accustomed to many of the Internet giants doing just that, pushing the envelope and enriching their lives with a better, faster, or more convenient way of content consumption.
One of the many struggles that Internet-based entities have is not only how to create these new products, devices, or programs, but also how to monetize such breakthrough endeavors successfully. In a fast-changing environment, it is never easy to deliver sustainable, profitable and innovative growth. Let’s take a look at the most recent quarterly performance of Internet giants Yahoo! (YHOO), eBay (EBAY), Amazon (AMZN), and Alphabet (GOOG, GOOGL), formerly Google. eBay and Alphabet are holdings in the Best Ideas Newsletter portfolio.
Yahoo! Sacrifices Short-Term Profit for Long-Term Focus
Yahoo! is working toward a narrowed focus on fewer products with higher quality for improved profitable growth. Though revenue performance may not be as bad as some are making it out to be, earnings continue to face pressure. GAAP revenue advanced 7% to ~$1.2 billion in the third quarter of 2015 from the year-ago period, driven by a 14% increase in display revenue. Gross search revenue grew 2% on a year-over-year basis. Mobile revenue grew from 20% of traffic-driven revenue in the third quarter of 2014 to 24% in the third quarter of 2015, and the company’s Mavens growth strategy–which focuses on mobile, video, native, and social initiatives–accounted for 38% of traffic-driven revenue in the quarter, up from 29% in the comparable period in 2014.
Sustainable growth in Yahoo’s top line is still of significant question given competing online advertisers in the likes of Facebook (FB), Google and Twitter (TWTR), but costs are ballooning, too. The firm reported a GAAP operating loss in the third quarter as traffic acquisition costs more than quadrupled from the year-ago period, to a total of $223 million. The company’s agreement with Mozilla was a primary contributor to the issue, as the cost of search revenue increased from $3 million in the third quarter of 2014 to $119 million in the third quarter of 2015. The cost of display revenue more than doubled on a comparable basis as well. Yahoo also included an asset impairment charge of $42 million in relation to a change in strategy of on certain long-term video content, and a restructuring cost of $26 million related to resource realignment considerations in its operating loss in the quarter.
Yahoo has made it very clear that its operations are not where it needs them to be, and its reported earnings have reflected that sentiment. In addition to the restructuring and narrowed focus, the company has stated that completing the spinoff of Aabaco Holdings is its top priority. The tax implications of the spinoff remain uncertain, and if the tax burden is eventually handed to shareholders, it could spell big trouble for Yahoo’s share price. We just don’t see much of an investment opportunity in Yahoo’s shares at the moment. It seems as though the IRS could slap the company with a fine at any time.
eBay Performs Well in First Quarter Without PayPal
In its first quarter without former subsidiary PayPal (PYPL), Best Ideas Newsletter portfolio holding eBay reported solid operational results. The company delivered strong top-line expansion as it continued to execute on its strategy of profitable long-term growth. Gross merchandise volume increased 6% on a currency-neutral basis in the quarter, and the firm’s number of active buyers on a trailing 12-month basis grew 5%, to 159 million. These factors drove revenue 5% higher in constant-currency terms in the quarter from the year-ago period.
Showcasing the earnings leverage inherent to its business model, eBay’s bottom-line growth outpaced its pace of revenue expansion in the third quarter. The firm grew income from continued operations by 7% on a year-over-year basis as operating expenses as a percentage of revenue dropped nearly 70 basis points. Reduced sales and marketing costs accounted for the primary source of the reduction. The company realized solid free cash flow of $462 million in the quarter, despite a significant increase in capital expenditures; it holds a solid net cash position of $0.6 billion, despite a rather large total debt load.
Aside from helping to drive management’s decision to raise its full-year 2015 non-GAAP earnings-per-share outlook, to the range of $1.80-$1.82, the most impressive aspect of eBay’s solid performance in the third quarter, in our view, was that the company completed a complex transaction in the middle of doing so! Updated 16-page reports on both eBay and PayPal will be published soon, and both will remain holdings in the Best Ideas Newsletter portfolio.
Amazon Continues to Expand Its Operating Margin
Amazon continues to grow at an incredible rate. The firm reported net sales increasing 23% on a year-over-year basis, to a total of $25.4 billion in the third quarter; excluding foreign exchange headwinds, net sales grew 30%. Sales growth is not expected to slow significantly in coming quarters. The troubling outlook for many big box retailers including Walmart (WMT) speaks to continued strength at the Internet retailing giant. Amazon expects a “record holiday season,” which indirectly bodes well for eBay, too.
The real story at Amazon lately has been its improving margin though. Income from operations experienced a nearly $1-billion swing to a profit of $406 in the most recently-completed quarter from a loss of $544 in the third quarter of 2014. Amazon’s trailing twelve month operating margin was at its highest point in the company’s history at the end of the third quarter. Most of the strong operating performance fell right to the bottom line, too, with net income of $79 million in the third period of the year, compared to a net loss of $437 million in the year-ago quarter. Compared to the third quarter of 2014, the company’s operating margin has swung more than 4 percentage points.
The significant margin expansion has driven Amazon back to profitability, and it has also boosted free cash flow considerably. In the trailing twelve month period ending September 30, the Internet retailing giant generated free cash flow of $5.4 billion, nearly 5 times more than the comparable period last year! Continued optimization of free cash flow remains a long-term goal at Amazon. We love this kind of focus on cash flow generation, as well as the solid net cash position the company holds on its balance sheet.
However, shares remain too pricey for our taste, and we just can’t get comfortable with management’s guidance and the sensitivity of its fair value to changes in its operating margin. In the current fourth quarter, for example, operating income is expected to be between $80 million and $1.28 billion, a huge range. A one percentage-point change in the company’s mid-cycle operating margin assumption translates into a $50 per-share change in its fair value estimate.
Alphabet Expands Operating Margin While Investing for Innovation
The company formerly known as Google may have a new name, but it has continued its terrific performance track record. In the third quarter, the firm grew reported revenue by 13% on a year-over-year basis, to $18.7 billion; when excluding the negative impact of foreign exchange rates, its revenue growth was an impressive 21%. This top-line growth was driven by substantial mobile search growth, as well as contributions from YouTube and programmatic advertising. The company now has six products or websites in its network that have over 1 billion users worldwide.
Alphabet’s ability to leverage its traffic acquisition and sales and marketing costs has been nothing short of impressive. The firm was able to expand its GAAP operating margin by 2 percentage points in the quarter even as it increased R&D spending by a full percentage point of revenue. This type of expense allocation will be imperative for the company, as it seeks to fulfill a mission to have its hand in everything from A to Z–hence the new name Alphabet. The solid margin expansion that took place in the quarter drove the company’s non-GAAP earnings per share nearly 18% higher from the year-ago period, to $7.35 per share. Profitable innovation is the name of the game at Alphabet.
The biggest news in Alphabet’s quarterly release, however, was that management will finally be returning cash to shareholders, something we outlined previously that would send the stock surging in our January 2015 note here:
Google’s cash has considerable value, but investors continue to discount its war chest. We think this spells opportunity. We value the search giant’s shares north of $650 each, a significant premium over the ~$500 mark at which it was trading hands during the after-hours session following its fourth-quarter report. Should Google decide to buy back its underpriced stock in the near future, we’d expect shares to surge on the news.
The high end of our fair value range for Alphabet is now over $800 per share, and we would not be surprised to see shares of both classes of stock around those levels soon, even as the buyback currently only covers the class C variety, GOOG. The firm remains a core holding in the Best Ideas Newsletter portfolio, and we have no plans of changing that. G is for Google, but could also be for good, great, or glorious. Better yet, G is for gainful. To us, G means grateful. We’re grateful to have you, our member, and we trust you are profiting greatly from our best ideas!